With the U.S. hurricane season officially kicking off this month, participants in the esoteric sector of catastrophe bonds find themselves awkwardly in step with the mainstream. As speculation abounds over hurricanes making landfall in the U.S. again this year, all eyes are focused on and the probability for destruction.

But for the CAT bond market, a far more important indicator signals the start of the hurricane season - updated figures from agencies that model catastrophe risk. This year's updates, which don't look promising, triggered a negative credit outlook announcement by one rating agency for certain bonds tied to U.S. hurricane risk.

Standard & Poor's analysts placed $1.476 billion worth of CAT bonds on credit watch negative last week, while it reviews the updated modeling information. These agencies, Applied Insurance Research (AIR), EQE International's EQECAT, and Risk Management Solutions, say updated modeling shows hurricanes would be more devastating in the near term than initially predicated.

The CAT bonds under review by S&P were issued by a variety of issuers, including Converium Holding AG, Hartford Fire Insurance Co., Swiss Reinsurance Co., PXRE Reinsurance, Montpelier Reinsurance, and USAA Casualty Insurance Co. Of the notes issued, few are highly rated with just Arbor II Ltd. Series 1, issued by Swiss RE, currently rated A+,' and Hartford Fire Insurance's Foundation Re's class B series 2004-1, is currently rated triple-B plus. Elsewhere, nine notes on watch are rated BB+;' two are rated BB;' two are rated B+;' and eleven notes are currently rated B.'

S&P analysts said they expect to lower the ratings on certain notes by one to two notches in most cases, due to the criteria change.

Year-to-year, change induced by catastrophe modeling is "usually diminutive," said Gary Martucci, an analyst in S&P's insurance group. This year, however, updated models information produced indications that the probability of these CAT bonds loosing the first dollar - the standard to which S&P rates for - seems to be 40% to 50% higher than usual, he said. Final results are pending.

Secondary market traders said spreads widened slightly on a few bonds named in the release, following the announcement. One secondary market trader said prices for the double-B classes dropped about one dollar point after news, to about $98.5 from $99.5 the prior day. He declined to be named.

The credit watch negative outlook is expected to lift in the coming 30 to 45 days, replaced by specific pronouncements about each note in question, said David Zuber, a catastrophe bond analyst at S&P.

"We went to resolve it before the de-facto hurricane season begins," Zuber said, meaning that while June is the official start of the hurricane season, historically tropical storms (which can turn into hurricanes) don't begin appearing in numbers until mid-July. August is considered the first hot bed month for US hurricane activity, experts said, maxing out usually in November; however storms raged in the Atlantic well through December of last year.

Should those notes become downgraded, expect secondary market activity to pickup, a bit of a change from the norm, said sources. Traditionally, CAT bonds are a buy-and-hold instrument, with many bonds bearing maturities of just two to four years.

"We are seeing a lot of activity in the secondary market, as investors readjust, or anticipate readjusting their portfolios," said Barney Schauble, a principal at Nephila Capital, a hedge fund manager dedicated to insurance-linked securities, catastrophe bonds and weather derivatives. Some investors will have to sell the bonds because they won't be rated double-B plus, he said. Sinking below that level places many notes well below investment grade ranges, preventing many investors from holding onto them due to portfolio criteria. Nephila, however, is unlikely to do much selling, if any, Schauble said, because the firm is less ratings sensitive than the average bond buyer.

Can the market deal with increased storms?

A widespread sell off in CAT bonds linked to hurricane risk in general is not expected, said numerous market sources. That's because as far as natural perils go, hurricanes moving from formation to actually causing destruction, is, fortunately, somewhat hard to achieve. The list of factors tied to US hurricane risk assessment is as fascinating as it is long.

Rating agencies rate a wide variety of CAT bonds, but much of the underlying information they tap comes from catastrophe risk experts like AIR. As a result of different modeling strategies, AIR is one modeling agency not predicting a large increase in losses from hurricane risk, said S. Ming Lee, executive vice president at AIR.

"There have been two years of increased hurricane activity. However, we shouldn't automatically jump to the conclusion that hurricane losses will increase by 50%," Ming said. "There is no one single metric that you can use for forecasting hurricane activity."

Hurricane activity runs in cycles that span decades and coincide with warming and cooling water temperatures. Sea temperatures are now warmer, and hurricane activity has increased, but the cycle actually began back in 1995.

And sea temperature alone is not the only factor utilized in looking at hurricane risk. The patterns of El Nino and La Nina play a role, as periods of El Nino tend to coincide with less hurricanes forming in the Atlantic compared to when La Nina is present; however these atmospheric-related events themselves fluctuate in two to three year, or even eight year, cycles. Other atmospheric phenomena tied to winds found at extremely high-in-the-sky, or stratospheric levels, are another factor, and when these winds flow westerly they tend to help hurricanes form, experts believe. Furthermore, a high pressure system in the Atlantic, dubbed the Bermuda High, which helps determine the path of hurricanes heading towards the US or, say, Africa, can fluctuate weekly or bi-weekly. All of these factors go into determining hurricane risk, explained Ming, and none of these guarantees a hurricane will even make landfall.

"In 2005, we moved into Greek letters for storm names because there were so many hurricanes, but there was actually more landfall in 2004," points out S&P's Martucci.

That said, investors are quite conscious of the fact that the last two years saw quite a few intense hurricane landfalls, with Charley, Ivan, France and Jeanne in 2004, and Katrina, Rita and Wilma in 2005, causing $100 billion in insured losses, according to industry data.

But the level of losses, some say, is exactly what's driving the CAT bond market to expand. New issuance continues as insurers and reinsurers are increasingly looking to the capital markets to help unload some of the risk.

"There is a lot of issuance this year, and there still is a lot of interest in the product," said Rodrigo Araya, a senior credit analyst at Moody's Investors Service. To date, none of the CAT bonds rated by Moody's has resulted in losses to note holders, he said of the market's performance. Araya added Moody's is unlikely to take any action due to the new modeling predictions; it only rated one of the notes included in the S&P list.

As far as new issuance goes, on June 7, Swiss RE announced a $950 million CAT bond program called Successor, a shelf-offering platform that issued several types of notes for protection against North Atlantic hurricanes, Europe windstorms, and California and Japan earthquakes.

S&P analysts said several new CAT bonds deals were in the pipeline but declined to provide details.

CAT bond returns remain attractive, and there is almost zero-correlation between CAT bonds and other financial markets risk, which makes CAT bonds a diversity play of sorts, many say. While some sources noted the market was likely to see a slowdown in issuance of CAT bonds tied to U.S. hurricane risks, market participants said that was due more to saturation of one type of risk than concerns about hurricanes wiping out the US coast line.

Nonetheless, images of Hurricane Katrina remain alive in the mind's eye; the insurance industry is still debating how costly that storm was.

"Katrina is an event that will be looked back upon as an inflection point for the market," Schauble says. She stated that the CAT bond market is growing because of how well it performed after Katrina.

Just one CAT bond linked to U.S. hurricane risk, KAMP RE, was downgraded following Katrina. Rating agency analysts confirmed no other CAT bond has been ever been downgraded to date.

(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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